Wednesday, June 23, 2010

Breaking Down a Put Spread

Suppose you like the current fundamental and technical outlook on gold and are considering throwing in your lot with the ever hopeful gold bugs. But with the SPDR Gold Shares (GLD) trading at $121 per share, let's say you're a bit skittish at the hefty price tag. While bullish risk rockets or other long stock strategies may be outside your price range, the cheaper vertical spreads may be an alternative worth your consideration. Let's breakdown an out-of-the money put vertical sell on GLD.

In choosing which month to use when structuring this play, some traders opt for front month options which offer an alluring higher rate of time decay. But remember these short term options aren't always sunshine and lolly pops, as they also include the often forgotten (or at least downplayed) gamma risk. Those favoring lower gamma risk over a higher theta typically prefer using longer dated options such as two or three months out. We'll go ahead and use August in today's example.

When it comes to strike selection, traders are faced with the dilemma of either going for a higher net credit and lower probability of profit or a lower credit and higher probability of profit. Suppose we settle on a happy medium between the two by going far enough out-of-the-money to feel comfortable with the profit zone, but close enough to still receive a sufficient return. Consider the risk graph of the Aug 115-110 put spread below.

[Source: MachTrader]

Provided GLD remains above $115, we stand to gain $89. While traders can certainly hold to expiration to capture the whole enchilada, it's usually prudent to exit when the majority of the profit has been achieved.

For related posts, readers can check out:
Ratios, Ratios, and More Ratios
Public Enemy #1
Time to Shine?

1 comment:

Penny Stock Newsletter said...

I would like to comment about open table new issues are almost always bad investments the vast majority of these stocks are way over priced on purpose. I always recommend that investors stay away from these stocks and with the exception of stocks trading under 1 dollar that traded on the over the counter bulletin board or pink sheets. that if they decide to buy penny stocks they should stay with stocks trading between 1 dollar and 5 dollars a share that trade on the new york stock exchange or nasdaq. and only buy stocks that have up to date complete financial infomation available. apple computer was trading at only 5 dollars a share in 1998 today the shares trade at 340 dollars a share. and ford motors stock traded at just 1 dollar a couple years ago. today the shares trade at 16 dollars. their are many stocks today that once traded under 5 dollars a share. I think stocks under 5 dollars carefully chosen can sometimes be great great investments unlike new issues.